Stay away from small-cap bank stocks.

It was nearly two years ago now that Tim first dished out that advice. Though they looked cheap at the time, writedowns were happening across the industry, making financial institutions nearly impossible to value. On top of that, the economy was showing signs of sputtering with no resolution in sight.

Not much has changed
It's hard to believe, but the current economic downturn is two years old now -- and it's gone from bad to worse. Notwithstanding the recent rising tide in the market, stocks have gotten "cheaper," writedowns have gotten bigger, and the federal government is throwing Hail Mary passes in the hopes of averting further crisis.

And while big financials such as AIG , Fannie and Freddie , JPMorgan (NYSE: JPM), and Wells Fargo (NYSE: WFC) have dominated the headlines, smaller financials have been hit just as hard. In fact, Fifth Third Bancorp (Nasdaq: FITB) and First Horizon (NYSE: FHN) have lost 55% or more of their value since this crisis began in late 2007!

All of this is to say, it's still not time to start buying small-cap banks.

It may, however, be time to start looking hard at something a little off the beaten path: small-cap value.

What's the difference?
Small-cap value and small-cap banks often get conflated -- and for good reason. As Brian noted last year, the Vanguard Small-Cap Value ETF (VBR), like most small-cap value indexes, has substantial exposure to small banks. For the quarter ending June 30, small financial services companies accounted for 33% of VBR's holdings.

So while you don't want to buy small-cap banks, you do want to buy small-cap value net of banks because, as Mark Hulbert noted in a New York Timesarticle at the end of 2008, these historical outperformers"produce their most explosive gains right at the start of a bull market."

Indeed, Russell Investments recently released a report suggesting that "they could emerge as the frontrunners if the economy stages a recovery." Year to date, small-cap value has outperformed the S&P 500 by five percentage points.

Let us be clear
Nonetheless, neither we nor Hulbert are predicting that we're at the start of a bull market. Rather, we're noting that:

And thus: Now is a good time to start buying small-cap exposure for the long term.

After all, a little exposure to this market segment gives you the chance to take advantage of this historical trend and puts you in position for significant outperformance whenever this bear market turns for good.

What next?
Hulbert's recommended small-cap value investment vehicle, while low-cost, is imperfect, because he advised investors to "buy and hold an index fund benchmarked to the sector and to ride out the market's turbulence."

We see two main issues with that approach. First, as we mentioned previously, your run-of-the-mill small-cap value index has nearly one-third of its assets in financial companies -- a sector that has been and will continue to be rocked by government intervention, regulatory changes, and low interest rates. Continued...